The Relationship between Sustainability Performance and Financial Performance

1. The Relationship between Sustainability Performance and Financial Performance Dr. Olaf Weber Export Development Canada Chair in Environmental Finance, SEED, University of Waterloo

2. Content Introduction EBITDA and Sustainability Performance Credit Risk and Sustainability Performance SRI Funds and Sustainability Performance Conclusions

3. Two Possible �Cause and Effect� Relations between Sustainability Performance and Financial Performance Financial performance influences sustainability performance investing in community relations and charity Sustainability performance influences financial performance energy-efficiency measures to reduce energy costs 3 So far we talked about a relation. However, we did not discuss the direction of the relation. Thus there are mainly two directions Financial performance influences environmental performance and environmental performance influences financial performance Financial performance influences environmental performance means that for example Investing in community relations and charity is only done if the company was successful and thus can afford the costs for investing in the community, charity or environmental issues. Environmental performance influences financial performance, means that it pay to be green. Examples are energy-efficiency measures to reduce energy costs Thus a Win-win-situation is creating a positive impact on the companies success and on the environment. So far we talked about a relation. However, we did not discuss the direction of the relation. Thus there are mainly two directions Financial performance influences environmental performance and environmental performance influences financial performance Financial performance influences environmental performance means that for example Investing in community relations and charity is only done if the company was successful and thus can afford the costs for investing in the community, charity or environmental issues. Environmental performance influences financial performance, means that it pay to be green. Examples are energy-efficiency measures to reduce energy costs Thus a Win-win-situation is creating a positive impact on the companies success and on the environment.

4. Research Results on the Relationship between SD and Financial Performance 4 Let us have a look on some research results. Margolis and Walsh analysed a high number of studies on the relation between environmental and financial performance. They came to the conclusion that a majority of these studies reported about a positive relation between environmental and financial performance. A small number reported about a negative relation, meaning that high environmental performance creates costs or diminishes returns. About 20 studies reported a small relation and about 15 reported mixed results that could not confess a positive or a negative relation. Thus let us explore these results, find arguments for them and try to explain why there is such a variance. Let us have a look on some research results. Margolis and Walsh analysed a high number of studies on the relation between environmental and financial performance. They came to the conclusion that a majority of these studies reported about a positive relation between environmental and financial performance. A small number reported about a negative relation, meaning that high environmental performance creates costs or diminishes returns. About 20 studies reported a small relation and about 15 reported mixed results that could not confess a positive or a negative relation. Thus let us explore these results, find arguments for them and try to explain why there is such a variance.

5. Three Kinds of Relations Positive Good Sustainability performance creates successful business Negative Good Sustainability performance creates less successful business environmental initiatives are applied poorly Neutral SD performance and corporate success are independent 5 Generally there are three kinds of relations between environmental and financial performance A Positive relation means: Good environmental performance creates successful business. It does pay to be green. Maybe because it reduces costs or attracts more clients. A Negative relation means that good environmental performance creates less successful business. It costs to be green. Maybe because investments in environmental issues are not rewarded by the market or the clients A Neutral relation means that environmental performance and corporate success are independent. Generally there are three kinds of relations between environmental and financial performance A Positive relation means: Good environmental performance creates successful business. It does pay to be green. Maybe because it reduces costs or attracts more clients. A Negative relation means that good environmental performance creates less successful business. It costs to be green. Maybe because investments in environmental issues are not rewarded by the market or the clients A Neutral relation means that environmental performance and corporate success are independent.

6. Why a Positive Effect of SD Performance on Business? Access to Markets/Regulatory Approvals Customer Attraction/Retention Address Media/Activist Pressures Discounted Loan Rates Reduced Insurance Premiums Operational Efficiency Due Diligence Regarding Partnerships/Acquisitions Legal Due Diligence/Assurance Employee Satisfaction/Retention/Productivity Industry Self-Regulation Facilitate Divestitures SRI Funds (Retail/Institutional) 6 Why a positive effect of business performance on environmental performance? This means business success causes environmental performance. Successful business creates good environmental performance because of The ability of a company to invest in environmental issues. This ability is the result of high financial returns. Another argument is that good management practices influence both business success and environmental performance. Thus a general management factor is responsible for all kinds of performance of a firm. Why a positive effect of business performance on environmental performance? This means business success causes environmental performance. Successful business creates good environmental performance because of The ability of a company to invest in environmental issues. This ability is the result of high financial returns. Another argument is that good management practices influence both business success and environmental performance. Thus a general management factor is responsible for all kinds of performance of a firm.

7. Why a Negative Effect of Sustainability Performance on Business? higher costs end of pipe environmental technology lower benefits environmentally friendly products are not accepted by consumers because of high prices Sustainability performance has been poorly applied investing in the wrong fields (offsets vs. technology) 7 But there are some studies showing a negative correlation as well. But why is there a negative effect of environmental performance on business performance? Some authors argue that Good environmental performance causes less successful business because of higher costs, for example for end of pipe environmental technologies that do not create any financial return. Furthermore there could lower benefits because environmentally friendly products are not accepted by consumers because of high prices or other reasons. But there are some studies showing a negative correlation as well. But why is there a negative effect of environmental performance on business performance? Some authors argue that Good environmental performance causes less successful business because of higher costs, for example for end of pipe environmental technologies that do not create any financial return. Furthermore there could lower benefits because environmentally friendly products are not accepted by consumers because of high prices or other reasons.

8. The influence of Sustainability performance is too small compared to other influences Sustainability performance is not perceived by the market 8 There are some cases as well where the relation between financial and environmental performance is neutral. There the influence of environmental performance is too small compared to other influences. This could be the case in sectors that are not strongly dependent on environmental resources or that do not emit a lot. Furthermore the environmental performance of a company is not perceived by the market. Thus the price of a security is not correlated to the environmental performance. There are some cases as well where the relation between financial and environmental performance is neutral. There the influence of environmental performance is too small compared to other influences. This could be the case in sectors that are not strongly dependent on environmental resources or that do not emit a lot. Furthermore the environmental performance of a company is not perceived by the market. Thus the price of a security is not correlated to the environmental performance.

9. Negative and Positive Effect for Portfolios:Portfolio Theory vs. Socially Responsible Investment (SRI) What happens if non-sustainable companies are excluded from the investible universe? Positive effect: non-sustainable companies are destined to mediocre financial performance Negative effect: constraining the investible universe is destined to mediocrity Does sustainability correlate with financial performance? 9

10. Sustainability Performance and EBITDA Margin Earnings Before Interest, Taxes, Depreciation and Amortisation margin (EBITDA) EBITDA margin is EBITDA divided by total revenue It measures the extent to which the cash operating expenses use up revenue 10

11. The Influence of Sustainability Performance onEBITDA Margin Study based on ASSET4 / Thomson Reuters ESG data More than 100 companies Sustainability drivers Sustainability outcomes 11

12. Sustainability Drivers and Outcomes Drivers Based on reporting Strategies and operations to manage sustainability performance Outcome Based on quantitative measures Positive impact on the environment or the society A company may have a state of the art environmental management system, but very high CO2 emissions 12

13. Indicators Analysed Environmental drivers Materials Energy Water Biodiversity Emissions Products and services Compliance and expenditures Environmental outcomes i.e. CO2 emissions 13

14. Model 14

15. Environmental Outcomes by Sector 15

16. Environmental Drivers and EBITDA per Sector 16

17. Environmental Outcomes and EBITDA per Sector 17

18. Environmental Drivers and EBITDA 18

19. Environmental Outcomes and EBITDA 19

20. Multiple Regression Models for Drivers and Outcomes There is a positive influence of the outcomes on EBITDA margin 20

21. The Relationship between Sustainability Performance and Financial Indicators 21

22. Conclusions (EBITDA) There is a positive relation between sustainability performance and EBITDA margin Generally the positive relation between sustainability outcomes and EBITDA margin is stronger than between sustainability drivers and EBITDA margin The sustainability result counts 22

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24. Credit Risks and Sustainability Credit Risks Credit risk is the uncertainty about the future outcome of loans Compliance with the credit agreement Default (non-compliance with the credit agreement as defined by Basle II) Sustainability Credit Risk Uncertainty about the future outcome of loans emerging from environmental, economic and social sustainability risks 24 Let me shortly give a definition on credit risk and sustainability credit risk: Credit risk is the uncertainty about the future outcome of loans. That means the compliance with the credit agreement vs. the non-compliance (default) as it is defined in the Basle II guidelines as the international framework of financial risk regulation. Sustainability credit risk is the uncertainty about the future outcome of loans emerging from environmental, economic and social sustainability risks. Let me shortly give a definition on credit risk and sustainability credit risk: Credit risk is the uncertainty about the future outcome of loans. That means the compliance with the credit agreement vs. the non-compliance (default) as it is defined in the Basle II guidelines as the international framework of financial risk regulation. Sustainability credit risk is the uncertainty about the future outcome of loans emerging from environmental, economic and social sustainability risks.

25. Core Questions Does a commercial debtor�s sustainability performance affect its credit risk rating? Does adding criteria aimed at assessing a debtor�s sustainability performance provide added value to traditionalfinancial rating criteria? 25 Who is that man on that slide and what's his problem? He is confronted with a commercial debtor and during the credit interview he saw his site. What he saw rose fears whether those environmental risks caused by the contaminated site has an influence on the debtors default risk. Has it an influence on his liquidity, the value of the security or general the risk of default? That real situation of banks in the 1990 motivated me to start my research on environmental credit risk management. So lets present my core questions that I wanted to answer: Does a commercial debtor�s economic, environmental and social performance affect its credit risk rating? Does adding criteria aimed at assessing a lender�s environmental, social or sustainability practices provide added value to traditional financial rating criteria? Does the integration of sustainability criteria improve the credit risk prediction? Who is that man on that slide and what's his problem? He is confronted with a commercial debtor and during the credit interview he saw his site. What he saw rose fears whether those environmental risks caused by the contaminated site has an influence on the debtors default risk. Has it an influence on his liquidity, the value of the security or general the risk of default? That real situation of banks in the 1990 motivated me to start my research on environmental credit risk management. So lets present my core questions that I wanted to answer: Does a commercial debtor�s economic, environmental and social performance affect its credit risk rating? Does adding criteria aimed at assessing a lender�s environmental, social or sustainability practices provide added value to traditional financial rating criteria? Does the integration of sustainability criteria improve the credit risk prediction?

26. Sustainability Risks in Credit Business Security risks of sites used as collateral that are contaminated Contamination of a site affects the collateral value Reputation risk Banks can attract a bad reputations because of bad reputation of a debtor Influences on the ability to repay the loan Debtors can be obliged to invest in environmental technologies because of regulations Changes in environmental attitudes of consumers or industries influence the business performance of a debtor 26 What are those sustainability risks in credit business? Firstly, there are security risks of sites used as collateral that are contaminated: The contamination of a site affects the collateral value. Secondly, there is reputation risk: Banks attract bad reputations because of bad reputation of a debtor Thirdly, there are environmental influences on the ability to repay the loan: Debtors can be obliged to invest in environmental technologies because of regulations or changes in environmental attitudes of consumers or industries influence the business performance of a debtor Generally we found that in about 10% of credit defaults of commercial loans in Germany environmental risks have an influence (Scholz, Weber et al. 1995). Thus a commercial credit portfolio of about CAD 3 Billion contains defaults of about CAD 1.5 Million (10% of 0.5%). However there are many interactions between sustainability and financial credit risks. What are those sustainability risks in credit business? Firstly, there are security risks of sites used as collateral that are contaminated: The contamination of a site affects the collateral value. Secondly, there is reputation risk: Banks attract bad reputations because of bad reputation of a debtor Thirdly, there are environmental influences on the ability to repay the loan: Debtors can be obliged to invest in environmental technologies because of regulations or changes in environmental attitudes of consumers or industries influence the business performance of a debtor Generally we found that in about 10% of credit defaults of commercial loans in Germany environmental risks have an influence (Scholz, Weber et al. 1995). Thus a commercial credit portfolio of about CAD 3 Billion contains defaults of about CAD 1.5 Million (10% of 0.5%). However there are many interactions between sustainability and financial credit risks.

27. Credit Rating Criteria 27 Just for an overview I present the list of criteria we used. Those criteria were derived from scientific literature on sustainability. Additionally we used a standard traditional rating that was in use in more than 60 Swiss Banks at the time of the survey. However the traditional criteria are used in a similar way in most of the credit rating systems and thus are adequate to predict credit risks.Just for an overview I present the list of criteria we used. Those criteria were derived from scientific literature on sustainability. Additionally we used a standard traditional rating that was in use in more than 60 Swiss Banks at the time of the survey. However the traditional criteria are used in a similar way in most of the credit rating systems and thus are adequate to predict credit risks.

28. Results 28 Let me present the results, mainly the influences of the different pillars, traditional, economic sustainability, environmental sustainability and social sustainability criteria on the prediction o credit risk defaultLet me present the results, mainly the influences of the different pillars, traditional, economic sustainability, environmental sustainability and social sustainability criteria on the prediction o credit risk default

29. Predicting Credit Risk by Traditional Rating and Sustainability Indicators Traditional rating (logistic regression) Correct predictions = 81.1% AUROC = .91 Traditional and sustainability rating (logistic regression) Credit Risk = 5.10*trad.+2.14*econ. sust.+1.10*soc. sust.-1.44*env.sust.-21.87 Correct predictions = 85.7% AUROC = .94 29 After having checked the influence of the covariates I present the influence of the indicators on credit risks. Looking on the traditional rating first we found that as expected the traditional rating can predict credit risk in a significant way. We could correctly predict 81.1% of the credit cases correctly. Adding sustainability criteria improves the predictive validity of about 4% to 85.7%. At first sight that does not seem much, but it means a reduction of credit default of about 20% what makes a big difference in terms of money lost by credit defaults. However both function are significant. Generally we can see that the influence of traditional criteria is the highest as to be expected, then economic sustainability criteria follow. Social sustainability criteria have a positive influence an credit risk as well, while the influence of environmental criteria is negative though the univariate influence is positive as well. That means there is a correlation between environmental sustainability criteria and the other criteria. If this is the case the multivariate algorithm extract only that part of variance that is not correlated to the other variables and thus a negative sign can appear. However there is other explanation as well. There is a positive correlation between environmental and traditional criteria only for non-default cases and not for default cases. I refer to that a little later in the conclusions. But let me first explain the AUROC as a measure for the validity of the functions.After having checked the influence of the covariates I present the influence of the indicators on credit risks. Looking on the traditional rating first we found that as expected the traditional rating can predict credit risk in a significant way. We could correctly predict 81.1% of the credit cases correctly. Adding sustainability criteria improves the predictive validity of about 4% to 85.7%. At first sight that does not seem much, but it means a reduction of credit default of about 20% what makes a big difference in terms of money lost by credit defaults. However both function are significant. Generally we can see that the influence of traditional criteria is the highest as to be expected, then economic sustainability criteria follow. Social sustainability criteria have a positive influence an credit risk as well, while the influence of environmental criteria is negative though the univariate influence is positive as well. That means there is a correlation between environmental sustainability criteria and the other criteria. If this is the case the multivariate algorithm extract only that part of variance that is not correlated to the other variables and thus a negative sign can appear. However there is other explanation as well. There is a positive correlation between environmental and traditional criteria only for non-default cases and not for default cases. I refer to that a little later in the conclusions. But let me first explain the AUROC as a measure for the validity of the functions.

30. Are Banks Integrating SD/Environmental Indicators into the Risk Management Process? 30 Thus lets us look on the results: They show that environmental criteria are integrated in the rating phase of the credit risk management process. UNEP signatories integrated it a little more�, but even non-signatories do that. However in the other phases environmental indicators are less used. The costs caused by environmental risks are not often calculated. However when it comes to the work-out of defaults environmental risks play a more important role again. It seems that they cause some of those defaults.Thus lets us look on the results: They show that environmental criteria are integrated in the rating phase of the credit risk management process. UNEP signatories integrated it a little more�, but even non-signatories do that. However in the other phases environmental indicators are less used. The costs caused by environmental risks are not often calculated. However when it comes to the work-out of defaults environmental risks play a more important role again. It seems that they cause some of those defaults.

31. Conclusions (Credit Risk) 31 Debtors may improve their credit ratings by improving their sustainability performance Banks may improve their credit risk prediction by integrating sustainability indicators into the risk management process Thus let me come to the conclusions: We could find answers to our core questions: A commercial debtor�s economic, environmental and social performance affects its credit risk rating Adding criteria aimed at assessing a debtor's environmental, social or sustainability practices provide added value to traditional financial rating criteria The integration of sustainability criteria improves the credit risk prediction. Thus a credit manager should use an integrated version of a rating system consisting of traditional ratings and sustainability ratings to predict the ability to repay, collateral values and reputations. Thus let me come to the conclusions: We could find answers to our core questions: A commercial debtor�s economic, environmental and social performance affects its credit risk rating Adding criteria aimed at assessing a debtor's environmental, social or sustainability practices provide added value to traditional financial rating criteria The integration of sustainability criteria improves the credit risk prediction. Thus a credit manager should use an integrated version of a rating system consisting of traditional ratings and sustainability ratings to predict the ability to repay, collateral values and reputations.

32. The Performance of SRI Funds in Times of Turmoil Is there a significant difference in the financial return between a portfolio of SRI funds and a conventional index during times of turmoil? Is there a relation between financial and sustainability ratings based on the past performance of funds and the return of an SRI fund portfolio in times of turmoil?

33. Database 151 SRI Equity Funds December 2001 to June 2009 Sustainability rating Monthly returns MSCI World as benchmark

34. Results: Returns between 2001 and 2009

35. Returns in Bull Phase

36. Returns in Bear Phase

37. Conclusions SRI Funds SRI Funds are able to outperform conventional benchmarks General market impacts influence SRI funds as well Sustainability rating alone does not guarantee outperformance The combination between sustainability rating and financial rating creates outperformance

38. The use of sustainability criteria in company analyses, credit risk evaluations and asset management may create financial benefits Cause-effect studies are needed From correlative studies to filtering out those that are able to combine sustainability and financial performance 38

39. Thank you! Dr. Olaf Weber Associate Professor, Export Development Canada Chair in Environmental Finance School for Environment, Enterprise and Development University of Waterloo oweber@uwaterloo.ca http://www.environment.uwaterloo.ca/sustainabilitypractice/